Five Subtle Sources of Risk

TOPICS

Much business forecasting is based on linear extrapolations or “regressions,” which see a future very similar to the past. This kind of thinking can be disastrous in assessing risk. Consider the real estate collapse of 2005-2006 or the management-cost growth on large projects as their complexity increases even modestly. Risk-takers must account for nonlinear surprises: twists and turns that result from interactive effects or systems pushed into unstable behavior.

FOLLOWING THE PACK

There’s a natural tendency to note where the “pack” is headed and go the same way. This has led to disaster in evacuation situations like the Station Night Club fire. In the investment world, a trading strategy might be good until too many investors join and thereby change the dynamics of the market itself. That factor also added vulnerability in the infamous Long Term Capital Management hedge fund collapse, with wide-ranging repercussions.

SELECTIVE HEARING

How many cities or states have made large financial commitments to support development proposals that failed to deliver as pitched? Think of Curt Schilling’s 38 Studios and its move to Rhode Island because of a huge loan guarantee by the state or the many locations that have not seen the promised advantages of hosting the Olympics. It’s just too easy to hear only what you want to hear.

MYOPIC VISION

Years ago I was assessing the risks at a chemical plant overseas; their data and procedures looked good. Then I asked about a big pile of metal junk sitting along the fence line: It was part of a ship that had exploded two years earlier while unloading chemicals! One piece hitting an on-site storage tank would have caused a major disaster, but since it didn’t fit into their typical safety analysis, they left it out. Resist studying only what presents itself in a straightforward fashion.

MURPHY’S LAW

Low-probability events can (and do) happen. In Japan, the Fukushima nuclear power plant is now an expensive and dangerous decommissioning project, due to an “impossible” tsunami. A photograph in my book shows utility workers removing a deer carcass from a power line about 50 feet high. This unlikely scenario caused a power outage in Missoula, Montana. When people mention black swans, I like to talk about my flying deer.